Energy sector bonds dominate the Russian corporate bond market and are responsible for more than 60% of the existing issue size. The sector is going through major expansion with some companies growing in double digits, and will continue to need major investment. There are also some risks specific to the Russian energy sector associated with uncertainties concerning the tax regime, sensitivity to international oil and gas prices that could cause instability of production, increasing costs caused by an appreciating ruble and increasing transportation expenses, and still artificially low domestic prices.

Still, in terms of fundamentals, nothing has changed in Russia. The magnitude of the recent sell-off of the corporate issues, especially of the oil issues triggered by the "Yukos affair," is not justified. Some of the oil issues represent extremely good value for the emerging market bond investors but we are hesitant to enter the market at the moment. Volatility in the market short term is to be expected, but there is a potential opportunity for bottom fishing unfolding in the near future.

_ As soon as there are signs of improving sentiment in the Russian marketplace, this would be a good opportunity to gain exposure to the entire sector. The top picks would be Sibneft 07 and 09s, TNK, and Gazprom 07 and 13s.

Russian Oil and Gas Credit Review: Improving Fundamentals, Attractive Value

How Do The Russian Energy Bonds Compare?

Oil and Gas Remains a Crucial Sector The oil and gas sector accounts for the largest part of Russia’s economy and budget (22% of GDP and 55% of exports). With an estimated 50bn bbl of proved reserves of oil and 30% of the world gas supply, the enormous Russian energy sector is a key area of interest for both strategic and portfolio investors. In the past 12 months there has been strong growth in the Russian corporate bond market, attracting many domestic and foreign investors. The energy sector, which is responsible for more than 60% of the existing corporate eurobond issue size, has been the centre of most interest. This report examines the positive factors that underpin the credit quality of the major issuers and some negative factors that still constrain their creditworthiness.

The 1998 economic crisis resulted in the state of Russia defaulting on some of its debt obligations and a sharp devaluation of the ruble. Despite the ensuing tough environment, most corporates managed to honour their debt obligations, banks excluded. Even the majority state-owned Gazprom met its debt obligations, despite its major shareholder’s default. Tatneft was the only oil company forced to restructure its substantial short-term debt obligations, which it could not pay.

Obviously the 1998-99 economic crisis was a severe test for the energy companies in Russia: lack of liquidity in the system, weak financial intermediation, low energy prices and investor disinterest all acutely lowered, if not stopped, investment coming into the sector.

Major Improvements Since 1998 Crisis _ Energy Prices Have Recovered
Since 2002, we have seen a sharp recovery of the economy, energy prices and the credit quality of the Russian oil companies. This largely underinvested sector started receiving much needed financing, with profitability and cash flow generation showing major improvement. Management has also come a long way in improving transparency, introducing international accounting and auditing standards. Clearly there has been a major improvement of the Russian oil majors.

_ Improved Credit Ratings
This improvement is reflected in the credit rating agencies’ upgrading of the corporates. The ratings in the oil and gas industry are among the highest in the country, with Yukos and Transneft ratings as high as the Russian Federation’s BB, according to S&P. Moody’s rating of Yukos is even higher at Ba1 (senior implied) vs. the Russian Federation’s Ba2. Any Russian corporate entity, regardless of its underlying credit quality, is subject to the ultimate Russian risk, which is why it cannot have a higher credit rating than its sovereign. However, it is encouraging to see that some leading companies, with strong franchises, good management and a certain amount of international recognition (as well as share listings in major international exchanges), value their corporate reputation and have grown strong enough to reduce, if not completely mitigate, Russian systemic risk.

_ Capital Markets Access
The improvement in the quality of the energy companies’ credit has been underpinned by strong crude prices, as well as a significantly improved operating environment, which is directly reflected in several credit rating upgrades of the Russian Federation. This in turn has triggered a major decline in yields, making financing in the international capital markets more accessible and cheaper for the corporates..

_ Financial Management and Leverage Most of the energy companies are pursuing an aggressive financial policy. They have been underinvested for a long time and are now in the process of upgrading their facilities, increasing production and acquiring oil and gas assets, either from privatisations or through consolidation by buying out their minorities. Although their leverage is increasing, there is a considerable amount of expensive short-term debt (up to 50% of total debt in the past) that has been putting constraints on their financial flexibility. Because of the lack of financial intermediation and liquidity in the past, the companies had no choice but to issue short-term debt by pledging their export receivables. Because of the much-improved fundamentals and lower cost of financing, management is now aggressively pursuing a policy of rolling over short-term debt into longer maturities. Gazprom is estimated to have saved almost US$1bn by optimising its debt portfolio.

_ Increasing Investments
Investments are now coming in substantial amounts to revive and expand this very much underinvested sector. Until 2000, most of the oil and gas production in Russia was stagnant, if not declining. The infrastructure lacked essential investment to continue and grow production. Now most energy majors are going through major capital expenditure by financing it increasingly from the strong cash they are generating, as well as primarily in the debt market.

_ Much Improved Corporate Image
Corporates have come a long way since the mid-1990s. Most energy majors now follow US GAAP and IAS financial reporting standards; some have introduced a corporate governance charter, improving their corporate governance, as well as their financial transparency and disclosure practices. They are gaining a better recognition in the international arena, which gives them better access to the international capital markets.

_ Better Management
Clear corporate strategies, the introduction of cost analysis, increasing shareholder value concepts, improved investment strategies, better financial management, optimising/ restructuring debt portfolios, increasing market capitalisation – all are a major shift in the quality of the current management of some of the energy majors. Barter sales, which used to account for more than half of the proceeds of some of the companies, are almost negligible. Asset stripping and legal fighting over minorities have diminished; consolidation of the assets and buying out minorities has brought better control and management of subsidiaries.

Why is the Corporate Bond Market Growing? _ Growing Leverage
Increasingly, Russian corporates are realising that the cost of equity is significantly higher than the cost of debt. This is a legacy of the 1990s equity bubble, as well as the Russian crisis of 1998, which had serious consequences in the Russian equity market. Given the volatility and increased premiums of the equity market, shareholders are demanding higher ROEs. Most of the major corporates are paying out good dividends and tapping into the bond market to increase their leverage in order to generate high return on equity for their shareholders. This is how replacing costly equity financing with increasingly cheap debt is done and it is a sign of good (or better) management. By doing this, corporates are increasing shareholder value. Russian blue chips are in a position to increase their value by between 20%-300% by increasing their leverage and dividend payments.

Leverage can only be increased as much as capital structures of these companies allow without risking the solvency of the company. Most Russian companies are extremely underleveraged, as in the economy in general, and are typically financed with high-cost equity. Also, most of the corporates are rolling their short-term loan facilities into long-term cheaper bond financing, preferably in the external market. The yields have declined from 13% to 9% in 10 months.

_ Sector is Growing
The oil and gas sectors in Russia have been going through a major expansion. In 2002, average crude production grew by 7.5%, with Sibneft achieving 27% and Yukos reaching 19% production growth. One of the main reasons behind this expansion is the government’s medium-term objective of reducing the federal budget and overall economy’s dependency on oil and gas prices. By encouraging the energy companies to increase investment, production and exports, the government, although still dependent on revenues from the sector, no longer depends on high oil prices as it did in 1998. Then the economy would have needed prices to reach US$26/bbl (Urals), whereas they fell to US$10/bbl. The 2003 budget assumes a price of US$18/bbl.

The bottom line is that energy majors are growing their production at double-digit levels and need to finance this growth through debt, not equity. Although we foresee some oil majors continuing their double-digit growth, there are some difficulties associated with oil pipeline bottlenecks, as well as increased costs of alternatives shipping arrangements. Nevertheless, the sector will probably remain the most important and sizeable attraction to equity and debt investors.

Risks _ Uncertainties Concerning Stability of Tax Regime Because of the crucial impact Russian energy companies have on the state budget, the federal government has a history of managing its taxation policy around its budget and debt service. The current tax regime, which was put in place during the high crude prices, has been stable and favourable. But going forward there is a risk of the government changing the tax regime, should international oil and gas prices become less favourable.

_ Exposure to International Oil and Gas Prices Although any company in the industry is subject to this risk, the Russian companies tend to have unbalanced production volumes. In the high crude price environment they are aggressively growing their production, but if the trend in the international commodity market reverses, we may not see such impressive double-digit growth. This would also impact FX cash generation. Increasingly, these companies are borrowing in hard currency (mostly US dollars). Although they still have limited leverage and strong debt coverage, an energy price collapse would lower their financial flexibility to invest and service their debt obligations.

_ Increasing Cost Base
Since the sharp depreciation of the ruble in 1998, the Russian energy companies have been enjoying a low cost base. This competitive advantage is now lessening due to the ongoing appreciation of the ruble. With the bottlenecks of the Russian export infrastructure, mostly on the back of limited pipeline capacity, companies are seeking alternative ways of transporting oil by rail or sea, which would significantly expand the cost base. Transneft, the 100%-state-owned monopolist that owns and operates the country’s only oil export pipeline network, is already using its full capacity. The fast growing oil production and increasing exports might soon outpace the expansion of the crude export infrastructure. Some oil majors are already considering building their own export infrastructure but we understand that there is no law allowing these private companies to have their own pipeline networks. The state is an arbitrator and it is all a matter of negotiations and reaching agreements, which we understand the companies are pursuing.

_ Limited Domestic Consumption; Artificially Low Domestic Prices Because of the transportation bottlenecks limiting exports and the declining domestic demand lagging production, the local market seems oversupplied. This is exacerbated by the fact that domestic prices are kept much lower than their international equivalents. To deal with this, most vertically integrated oils are substantially investing in their refineries to increase their downstream business, as the margins on ready oil products tend to be higher than the crude itself. Appreciating ruble revenues are also mitigating the increasing cost.

Main Players in Eurobond Market
_ Yukos-Sibneft – Story of The Year We believe that the merger of Sibneft with Yukos would greatly enhance the credit standing of Sibneft. Yukos is three times bigger than Sibneft and the new entity should have an improved rating given the overall low debt levels and improved capital base, as well as reduction in costs and combined revenues. Both companies boast a low cost structure, high reserves and faster growth than other Russian oils. Yukos is extremely well capitalised, with negative net debt (its net cash position is several times the size of its small liabilities). The new entity will, in our view, offer long-term potential through growth and operational efficiency.

_ BP’s Investment – The Largest of its Kind Following the merger with BP, TNK has set a new paradigm for evaluating this Russian oil major. No doubt the company will benefit from the know-how of the largest western oil company. We have yet to see the shape the newly formed entity will take.

_ Gazprom – Quasi Sovereign?
Apart from supplying 25% of European gas and 20% of the world’s gas supply, Gazprom is 38.5% state owned and of major strategic importance to Russia, as well as Europe. Although the company has become more commercially minded, the government still holds a tight grip. In case of financial difficulty (low probability) the state would be the lender of last resort, most probably by injecting liquidity by easing the taxation burden on the company. Overall there is a strong trend towards reforming the gas sector, as well as reforming Gazprom itself. This is very encouraging. The government has indicated its willingness to push for tariff reforms and liberalise the gas market. Gazprom would ultimately benefit from liberalisation of any kind.

At the same time, the government has indicated its willingness to increase its shareholding to 51%, and thus Gazprom remains a strong sovereign story (and risk). We see better upside in Gazprom’s spreads over the Russian sovereign issues.

_ Rosneft – One of The Last State Oils Rosneft, one of the last state-owned oil majors, is not as strategically important as Gazprom. Unlike Gazprom, Rosneft we view as just another asset that will eventually be disposed of. Although its financials look impressive, given the lower quality crude, limited transparency, and general lack of information as to management’s plans and strategy, the lower credit rating of the company, as well as the higher spread it is trading at compared with its peer group, is justified.

2. How Do The Russian Energy Bonds Compare?

Four major energy companies dominate the universe of Russian eurobonds: Gazprom, Sibneft, TNK and Rosneft. The intention of much-famed Yukos to come to the eurobond market with an estimated US$1bn issue, as well as its merger plans with Sibneft, would soon make the company a major player in the bond markets. The following is a relative credit assessment of the five majors.

Credit Quality
_ Profitability
We consider Sibneft and Yukos to be the two most profitable and efficient companies in their peer group. Although we do not expect these companies to sustain such high profitability ratios, due to the strengthening of the ruble, increasing transportation costs and higher interest expense, these are issues which affect the whole sector. Yukos and Sibneft are No.1 and No.2 in terms of operating and net income margins. They have the lowest cost/income ratio, as well as the highest return on equity and on total assets. If their merger goes successfully, they would become the No.1 oil major in Russia, by most measures.

In the meantime, from the universe of existing issuers, Sibneft tops the profitability and efficiency charts. Our rankings are as follows:

1. Yukos
2. Sibneft
3. TNK
4. Gazprom
5. Rosneft

_ Growth
Sibneft is in our view the fastest growing oil major in terms of production and revenues, followed by Yukos. We expect these companies to continue showing double-digit growth, but the increased operational, as well as interests costs would lower their bottom line. Sibneft has the biggest capital expenditure growth, which underpins its strong production, as well as technological superiority. We consider the net income numbers for Gazprom to be misleading, because of the uneven taxation.Our rankings are as follows: 1. Sibneft
2. Yukos
3. TNK
4. Gazprom
5. Rosneft

_ Leverage
While Gazprom has the lowest net debt to equity ratio, the conservatively managed Yukos runs a negative net debt. Currently, its cash balances are several time its existing liabilities. The company intends to increase its leverage after finalising its merger with Sibneft, as well as paying out some of its cash as dividends to its shareholders. The most leveraged names are TNK and Sibneft, although their strong cash flow generation is providing a good cover for servicing their debt. Our ranking by leverage and financial flexibility: 1. Yukos
2. Gazprom
3. Rosneft.

_ Coverage and Liquidity
With strongly capitalised Yukos out of the contest with its substantial cash balances and negative net debt, Rosneft and Sibneft emerge as top coverage providers for their debt. On the net cash flow basis, Sibneft and TNK our the top picks, due to their strong cash generation, which provides a good cushion for their debt obligations. Rosneft and Sibneft have the highest liquidity after Yukos. Our rankings are: 1. Yukos
2. Rosneft
3. Sibneft
4. TNK
5. Gazprom

Asset Quality
Gazprom’s enormous gas reserves and biggest gas pipeline system leave its asset quality and size unchallenged. If, over time, the gas giant manages to increase its local gas prices significantly, if not completely equalise them with international rates, the value of the company overall would manifestly be what it represents at the moment. Within the oil universe, we think Yukos and Sibneft have the best assets, both upstream and downstream, in terms of the size and depletion of reserves, the quality of their crude, as well as the technology applied in developing reserves.

Management and Corporate Governance 1. Sibneft
2. Yukos
We believe Sibneft’s management is superior to others in the peer group. We like management’s clear strategy and ability to turn the loss-making company into the fastest growing and highly efficient oil major. The management has a strong emphasis on cost control and high efficiency, as well as improving corporate governance and disclosure practices. With Yukos’s management being another top choice for us, we regard the planned merger as a union of undoubtedly the two best Russian companies in the sector.

3. TNK
Tyumen Oil would be the next on the list, with BP as its new strategic partner. Although we believe that the western involvement in the company would enhance its credit profile, we have yet to see the finalisation of the merger, consolidation of the accounts, or formation of new management. Time will show whether the new entity will be run as a western oil major, or at least capture the best of BP’s practices.

4. Gazprom
The company has gone through many changes since the arrival of the new management two years ago. Gazprom is increasingly being run as a commercial enterprise with improving disclosure and corporate governance practices. Management is very keen to increase Gazprom’s market capitalisation by improving investor relations practices, as well as lifting the limited foreign shareholding ban from the company.

5. Rosneft
Being a 100% state owned oil company means that Rosneft lacks an investor relations culture. Although the company publishes its accounts in US GAAP, there is limited access to management or its plans and strategies.

Overall Credit Assessment
Using the above credit measures, as well as qualitative assessment, our overall credit ranking is as follows: 1. Yukos

2. Sibneft
Overall, we view Yukos and Sibneft as the two best oil companies in our universe, in terms of profitability, efficiency, growth, financial standing, quality of assets, size, quality of management, corporate governance and disclosure. After the successful merger of these two companies (we attach an 80:20 probability of this taking place) we believe that the new Yukos-Sibneft would assume Sibneft’s existing debt obligations, which would make it extremely attractive, as the new entity would have a higher credit rating than Sibneft alone (Yukos BB/Ba1 vs. Sibneft B+/Ba3). Should the merger fall through and Yukos issue bonds on its own, we would rank Yukos as the No.1 overall credit story and Sibneft as No.2.

3. Gazprom
The following factors make Gazprom an attractive credit story in our view: improving efficiency, a superb asset base, its size, improving debt management, and, most importantly, its strategic importance to the Russian state and economy, as well its quasi-sovereign status..

TNK
Growing debt, aggressive financial policies on one side vs. 50% BP ownership and high profitability on the other. 5. Rosneft
Growing debt, limited efficiency, limited disclosure. Trade Recommendations -
_ Russian Risk Remains Oil and Gas Risk Overall we believe that as long as the Russian risk primarily remains an oil and gas risk, the energy sector issues should be trading as closely as possible to their comparable sovereign issues. While the Russian oil sector represents significant value for bondholders, it is imperative to understand the underlying story behind the individual credits.

_ The Ultimate Risk
Russian fundamentals are improving and the Russian companies are following this change. Yet Russia is still very much a country going through a transition, with all its trials and tribulations. Any attractive credit story with strong underlying fundamentals is still subject to the ultimate Russian risk and is to be viewed within this context. The events of the past few weeks surrounding Group Menatep’s shareholders and the Yukos executives showed us again that Russia is still an emerging market with its weak political institutions and state of law in its infancy.

_ Attractive on Fundamentals but it is Not the Bottom Yet We still believe that in terms of fundamentals nothing has changed in Russia and the magnitude of the sell-off of the corporate issues, especially of the oil issues, is not justified. Some of the oil issues represent in our view extremely good value for emerging market bond investors but we are hesitant to enter the market. While we expect a lot of volatility in the market short term because of the ‘ Yukos affair’, we see a potential opportunity for bottom fishing unfolding in the near future. This is subject to the Kremlin’s recognition of the magnitude of the damage to the Russia’s image in the international arena that current events are causing and the willingness of Yukos to call a truce.

_ What to Eye Up
We would consider signs of improving sentiment in the Russian marketplace as a good opportunity to gain exposure to the entire sector. While we believe the existing issues in the oil and gas sector represent good value to investors seeking medium- to long-term appreciation, the following would be our ranking in order of the highest possible upside:

Sibneft 07 and 09s. Both issues suffered the biggest hits because of the Yukos’ investigations and the risk of the merger falling through. Although we attach a low probability to the merger not being successful, we believe both issues represent the best value in our universe, even if Sibneft does not merge with Yukos. In the past month alone, the yields on both issues have increased by almost 240bp. TNK. The issue lost 170bp in the past month. The merger with BP is in the process of being finalised; if BP assumes TNK’s debt, we would expect a credit rating upgrade.

Gazprom 07, 09, 13s. Gazprom issues have diverged from other oil issues in the past two months and are increasingly following the pattern of the Russian sovereign issues. Although they have outperformed their oil peers (only losing up to 100bp), we view them as quasi-sovereign issues representing an extremely attractive carry vs. their comparable sovereign issues, with the spread to sovereign between 183bp-215bp. We particularly like the 07 issues trading at 215bp spread to Russia 07s. Over time, we see the Gazprom issues converging towards their comparable sovereign issues.
Rosneft. Although the issue is small (US$150mn) and very illiquid at spreads of 540bp to the UST and 310bp to its sovereign, it represents good value. While we foresee its spread to the sovereign narrowing, we do not believe it should trade as tightly to Russia ‘07s as Gazprom. While Rosneft is a 100% state-owned company unlike Gazprom, we do not attach the same magnitude of strategic importance to it and believe it should be trading at a discount to its peers.